The classic confusion in the minds of shareholders is whether growth companies are good investments. The answer is ‘yes and no’. Because, shares of growth companies are not always necessarily good investments. Recognition of this difference is absolutely essential for successful investing.
What is a growth company?
Growth companies are those companies that consistently experience above-average increase in sales and earnings. This definition has some limitations because many firms could qualify due to certain accounting procedures, mergers or other external events. So, literature provides another explanation for a growth company. Growth companies are firms with the ability and the opportunities to make investments that yield rates of return greater than the firm’s required rate of return. In addition, a growth company that has above-average investment opportunities should, and typically, retain a large portion of its earnings to fund these superior investment projects and generally it pays less dividend.
What is a growth stock?
A growth stock is a stock with a higher rate of return than other stocks in the market with similar risk characteristics. The stock achieves this superior risk-adjusted rate of return because at some point in time, the market undervalued it compared to other stocks. Although the stock market adjusts stock prices relatively quickly and accurately to reflect new information, available information is not always perfect or complete. Therefore, imperfect or incomplete information may cause a given stock to be undervalued or overvalued at a point in time.
Factors to be considered while identifying growth stocks:
Potential growth: As growth companies provide superior returns, it is essential to assess whether the potential growth in terms of revenue, profit margin, etc., are sustainable in the long run. If either the current market price is more than its intrinsic value, or its growth has slowed down, it is better to avoid those shares.
R&D expenses: To sustain in the market for a long time, companies need to either improvise their existing products and services or introduce new products and services. Though this is essential for all companies, for certain specific industries such as pharmaceutical, auto, etc., it is mandatory. While assessing the future growth of a company, investors need to pay attention to the R&D expenses of the company during the last couple of years and its correlation with the revenue.
Managing the challenges: Investors need to assess how companies respond and manage the challenges and how fast they respond and react. The changes could be either internal or external. For instance, how well a company handle a situation when the relevant laws were amended by the authorities.
Focus more on qualitative aspects: Sometimes financial analysis can miss out on identifying growth stocks. So, focus on qualitative aspects such as the promoters’ group, their interest in the business, board of directors and their expertise, representation of professional non-promoters in the board, employee friendliness, etc. which will help in identifying a growth stock.
To conclude, investing in a growth stock has high upside potential and vice versa. As an investor, if you invest in growth stock you should consistently monitor the same for any hidden weakness that could possibly lead to slow momentum.
The writer is professor of finance & accounting, IIM Tiruchirappalli